High-yield municipal bonds hit sector hard

In 2008, they fell an average 25.7%

Some of the worst-hit mutual funds are in the high-yield municipal sector, with some funds losing nearly half their value in 2008. That is despite a low default rate and enticing yields.

Funds that invest in high-yield, or junk-rated, muni bonds are down an average 25.7 percent this year, according to fund tracker Morningstar Inc. Of all fixed-income sectors, only ultrarisky corporate junk bonds (down 29.3 percent) and leveraged loans (down 30.1 percent) fared worse. In the same period, the Standard & Poor's 500-stock index is down 40.6 percent, and the Dow Jones industrial average is down 35.8 percent.

Even though few high-yield municipal issuers defaulted in 2008, and even though munis continue to provide stable, tax-free income, investors have been dumping them.

If any part of the muni market is most prone to defaulting, it is the high-yield area. These are typically lower-rated credits that depend on revenue that has a greater chance of drying up, such as from hospitals and nursing homes, where a slowdown in patient loads because of recession belt-tightening would have a big effect. Standard munis, issued by state and local governments, are backed by taxes.

Another problem for junk munis is that bond insurers are in trouble. It used to be that this coverage would bolster confidence in high-yield issuers, but no longer.

For junk muni funds, the deleveraging that has swept all fixed-income markets has been especially damaging. Like other funds, they are beset with redemptions, so they have had to join the selling frenzy to cash out anxious shareholders. Hedge funds, which used to buy a lot of these bonds, also are dumping them lately to raise cash and pay off exiting investors. That has put downward pressure on bond prices.

Selling has been rampant since July, and high-yield muni funds have reported $3.3 billion in investor net outflows, according to AMG Data Services. These funds reported $1.5 billion of inflows in 2007 and $10.1billion of inflows in 2006. Overall assets for high-yield muni funds are down to $32.3 billion from $54.5 billion at the end of 2007.

Oppenheimer's Rochester National Muni Fund tops Morningstar's list of the worst high-yield muni performers in 2008, with losses of 49 percent in 2008 to date. Its negative 10.3 percent showing in 2007 also was distressing, but before that, it was at or near the top of its category for years, returning about 10 percent from 2004 through 2006.

“You look at the riskiest, most volatile sectors of the muni market and they're there in a big way,” said Morningstar analyst Greg Carlson about the Oppenheimer funds. “It's paid off for them in past years, but this year it hurt them.”

The fund has roughly a quarter of its holdings in tobacco bonds, which securitize lawsuit-settlement payments to states by tobacco companies. Tobacco bonds typically have credit ratings in the BBB range, due in part to litigation risks, and don't trade frequently. That is a poisonous combination now.

Some of the fund's other big holdings include land-secured munis, which are bonds based on tax assessments that help pay for land development. These have sagged along with the housing market. Another soured bet: airline bonds, typically tax-exempt notes issued by airports that back terminals for carriers. Such bonds have suffered along with the airline industry.

Making matters worse, the fund bought long-term bonds with the help of short-term borrowing, which must be repaid because rolling it over is very difficult now. Thus it must sell still more long-term holdings – the average maturity of its bonds is 24 years – to pay off the short-term creditors.

The fund insists that this strategy will work well again, once bond prices rebound. Meanwhile, short-term rates remain helpfully low, while long-term rates are sharply higher. “Prices in our view are irrationally low,” said Daniel Loughran, a portfolio manager at the fund.

Remarkably, this fund has seen no net investor outflow, in spite of its poor performance – perhaps a testament to its previously impressive track record. A good selling point is its robust yield, 11.3 percent.